When QE2 turns QEBlue

A look at the insignificant impact QE2 is likely to make

In an effort to gauge the potential impact of QE2, the Federal Reserve this week asked investors and bond dealers for their six-month projection as to the volume of assets the central bank should purchase to spur economic growth and maximize employment, for the Fed had said in its September press release, "Household spending remains constrained by high unemployment, modest income growth, lower housing wealth and tight credit... Bank lending has continued to contract... Employers remain reluctant to add to payrolls."

How would QE2 help loosen household spending constraints? Unfortunately, it won’t. In order to create demand, Americans need more money in hand to spend at their favorite department stores. That cash will have to come by moving the ranks of the unemployed to employed, and by raising incomes. Billions of QE2 dollars will soon stream toward banks, but that is as far as they will flow. As the Fed statement indicates, bank lending is contracting because they see nothing of any economic significance that causes them to believe they are likely to collect on lent funds. Banks are already sitting on $1 trillion in excess reserves with the Fed that they are unwilling to extend, so what good will it do cash-strapped Americans to pad the pockets of the banking industry with another trillion? The buck literally stops at the banks! Bottom line, the purchasing “firepower” Americans relied on in supporting the U.S. economy – solid employment, rising incomes, rising home equity and access to credit – is gone. Fundamentally, there seems nothing QE2 (quantitative easing, round 2) can do to change this.

Can QE2 help to increase export jobs? Actually, the U.S. administration's official line is QE2 is not intended to devalue the dollar, which would make U.S. exports cheaper and more competitive. But unofficially, they welcome a weaker dollar to help boost exports. However, for the following reasons, QE2 will have little impact:

1) The services sector (retail, restaurants, hotels, banking, etc.) makes up more than 80% of the U.S. economy. Services-sector activities are not exportable, which leaves QE2 with less than 20% of the economy to affect;

2) Of the less than 20% of the economy that is exportable, the Top 10 industries are: civil aviation, semiconductors, passenger cars, pharmaceuticals, auto accessories, industrial machines, fuel oil, chemicals, telecommunication equipment and plastics. But much of this production activity takes place abroad;

3) The roughly 25 million U.S. small businesses employ half of the entire American workforce.

The result, with practically all 25 million small businesses being denied pre-crisis-level access to credit, right off the bat, half of the U.S. workforce will not benefit from QE2. Of the other half, the exporting 20% represents 10% of U.S. workers that could benefit from QE2, however, since more than half of that production is based overseas, this takes us from 10% to about 5% of the workforce who would gain from QE2. But even that 5% may be offset by the steady flow of manufacturing jobs leaving the U.S. for countries offering lower labor costs, a lower tax rate, and limited regulation. Thus, QE2, in effect, is a no-show at the shipping docks.

Might QE2 help domestic businesses grow? Not so much. The reason is that the large corporate Wall-Street insiders have already taken advantage of access to cheap money. So lowering borrowing cost by another few basis points will not move them to make meaningful changes to their post-crisis business models. They will make due with current employment and salary levels. But for smaller, less-connected companies, access to credit will largely depend on banks’ assessment of economic growth and company growth prospects. Hence, QE2 will hardly be noticed on Main Street.

So, if QE2 contributes little toward helping the Fed spur growth or create new jobs, what good is it?

1) QE2 will assist in keeping the U.S. officially out of recession since Treasury sales are included in the GDP report;

2) Since home-title litigation is posing a second major threat to the housing & financial markets, funds from QE2 will be used to stabilize banks, Fannie Mae & Freddie Mac via mortgage-related security purchases. The Fed is determined to protect its children (banks) by keeping mortgage rates low and supporting – if not, inflating – home prices. For if prices fall, banks would otherwise require another round of bailouts;

3) The administration may be bracing for a slew of layoffs in January. Pressure is mounting for many companies to either raise prices or reduce their workforce as rising energy and commodity costs are squeezing profit margins. QE2 could be used to fund unemployment extensions and other social safety nets to help mitigate social unrest. (Such support used to be done through “stimulus”, but has now become a politically incorrect process);

4) QE2 funds could be used to create government jobs on the fly in case private-sector jobs take a tumble.

Will QE2 substantially stimulate economic growth and reduce the unemployment rate? The evidence is stacked against it. Are the headline reasons for QE2, then, just excuses to run funds through the back door? We will know for sure if/when QE2 turns QEBlue.